Commentary: Analysts fail to accept changing sentiment, reality

CHAPEL HILL, N.C. (MarketWatch) — For a test case of Wall Street analysts’ perverse incentives, look no further than Apple Inc. After rising to giddy heights, the stock has been unable to catch a break lately.

That is in no small part due to those incentives, which cause bad news to get incorporated into stock prices only gradually. One surprising consequence, according to researchers, is that unfavorable news tends to come in waves rather than being randomly interspersed with good news.

Apple’s
AAPL, -0.35%
shares hit their all-time high of $705 on Sept. 21. At the time, the consensus forecast for Apple’s fiscal 2013 earnings — among the more than four dozen analysts tracked by FactSet — was $53.56 a share. That number has been revised downward numerous times: By the end of last year, for example, it stood at $49.08 — and currently is at $44.56.

With Apple’s stock 36% lower today than its September high, some investors might argue that the current consensus forecast is a case of closing the barn door after the horses have left. Unfortunately, the news is likely to get even worse, according to Michael Clement, an accounting professor at the University of Texas at Austin who has extensively studied analyst behavior. That is because a downward revision is more likely to be followed by yet another downward revision than by an upward one.

There are several sources of this tendency, he says. One is that analysts are slow to react to new information — especially when the news is bad. Part of their slowness is defensible: It takes time to analyze the often-complex developments that can affect a company’s prospects.

But other reasons are more questionable. For example, according to Clement, analysts often are reluctant to offend a company’s management, which might retaliate by restricting their future access. Analysts also are reluctant to upset institutional clients who own big positions in a stock, and who therefore don’t want the analyst to be talking its price down.

Because of these “powerful incentives to not get the bad news out,” as Clement puts it, the market reacts far more quickly to unfavorable developments than do the analysts themselves. As a result, the typical analyst is more likely to follow the market than lead it.

Consider what happened in the three weeks following Apple’s all-time high, when its stock fell by 10%. Far from taking that warning seriously, the average analyst became even more optimistic than he was previously. At the end of those three weeks, the consensus forecast was actually higher than at the beginning.

Only when Apple released its earnings a couple of weeks later, on Oct. 25, did it begin to dawn on analysts that the market had been right. In the wake of that earnings release, almost all of them revised their forecasts downward, causing the consensus estimate to drop to $50.24 a share.

But even that proved to be too little, too late. In fact, the same pattern played itself out again in the weeks leading up to Apple’s January earnings release. Its stock already had fallen another $100 or so over that period, even as the consensus was barely changing. And then, on the day of that release, the analysts en masse revised their forecasts downward — causing the consensus to fall to below $45 a share.

Even though the analyst community appears to be constantly playing catch-up with the market, Clement emphasizes that the analysts aren’t mere followers of the market’s lead. That is because the market itself also reacts when analysts eventually do revise their forecasts, he says. Apple once again provides a good illustration: In the three weeks since the company’s January earnings release, when almost all analysts revised their forecasts downward, Apple’s stock has dropped still further.

The complex picture that emerges from the research of Clement and others is of a downward spiral. The market reacts relatively quickly to unfavorable news about a company, followed by downward revisions in analyst forecasts, leading to even further declines in the company’s stock.

Though this downward spiral is frustrating to those holding shares of a company that is suffering from seemingly no end of bad news, there also is a way for traders to exploit the pattern.

The key is to avoid those companies for which recent analyst earnings forecasts have been reduced, and favor those stocks for which the recent revisions have been positive. Yet Wall Street’s reluctance to incorporate bad information suggests it is even more important to avoid the companies with downward revisions than it is to favor the firms with upward revisions.

So long as most analyst revisions continue to be down, of course, that list of companies to avoid would most definitely include Apple.

One investment-advisory service that picks stocks according to the trend in analyst revisions is Zacks Investment Research in Chicago. According to tracking conducted by the Hulbert Financial Digest, its Zacks Premium service has produced an 8.8% annualized return over the past 15 years, more than three percentage points per year better than buying and holding the stock market itself, as measured by the Wilshire 5000 total-return index. (An annual subscription costs $450.)

An example of a stock that the Zacks approach favors, because of the number of analysts who recently have upped their forecasts, is Valmont Industries
VMI, +0.51%
which makes utility poles and concrete structures. Quest Diagnostics
DGX, -0.35%
, the medical-testing company, is at the opposite end of the revision spectrum, according to Zacks.

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